Tax free income is a beautiful thing. There are really only three opportunities to generate tax free income: municipal bonds (which have restrictions and requirements), cash value life insurance, and Roth accounts.
If you have a job and access to a corporate retirement account like a 401k, 457, or 403b plan, then you can fund the Roth provision of that plan regardless of the amount of income you earn. However, for higher income earners (those earning over $153,000 who are single or $218,000 who are married filing jointly), the Roth IRA option is phased out by IRS rules. This means higher income earners may be eligible to fully fund the Roth provision inside the corporate retirement plan but unable to contribute to a Roth IRA.
There is, however, a strategy called a Back Door Roth IRA. The strategy starts with making an after-tax contribution to a traditional IRA. Anyone is allowed to make an after-tax contribution to an IRA regardless of income. The challenge with doing so is that the IRA custodians do not keep track of cost basis in IRA accounts. It’s the responsibility of the individual investor to keep track of the cost basis in the IRA and report that basis to the IRS on form 8606 annually. When the funds are withdrawn or converted from the account, the custodian will report all distributions as taxable on the 1099.
Once the non-deductible IRA contribution is made, a Roth conversion is processed, moving the after-tax funds from the IRA to the Roth IRA. Because the funds are an after-tax contribution only, the earnings on the original IRA contributions are subject to income taxes in the year of the conversion.
Let me give you an example:
John makes a non-deductible IRA contribution in the amount of $6,000 for the tax year 2022, and then files form 8606 notifying the IRS that he made an after-tax contribution to his IRA account. A few months later, John converts the IRA—which has grown to $6,500—to a Roth IRA. The original $6,000 that is converted isn’t a taxable event since no deduction was taken at the time of the original contribution to the traditional IRA. The $500 in growth is subject to income taxes because those funds have never been taxed. Once the conversion is made, then the funds will grow tax free—as long as the Roth IRA owner follows all of the IRS rules regarding Roth IRA withdrawals.
Sounds straight forward—and it is—except for one potential hang up: the Pro Rata Rule. The Pro Rata Rule determines how tax deferred money should be taxed upon withdrawal or conversion. When a portion of an IRA account is either withdrawn or converted, and if that account has both tax deferred funds that have never been taxed, and funds that have a cost basis or have already been taxed, then it triggers the Pro Rata Rule.
Here is an example of how the Pro-Rata Rule works:
John has an IRA account (i.e. Traditional, SIMPLE, SEP) with a $54,000 balance. This balance is all pre-tax funds with a $0 cost basis. John then makes his $6,000 after-tax contribution to his IRA account bringing the balance to $60,000. Inside John’s IRA, he now has $54,000 that has never been taxed and $6,000 that has been taxed. He moves the $6,000 contribution to his Roth IRA believing that 100% of it has been converted. John, however, has now triggered the Pro-Rata Rule. Upon initiating a conversion of after-tax dollars, the proportional percentage of pre-tax dollars to after-tax dollars must be part of the conversion calculation. The after-tax portion of the IRA equals 10% of the account value ($6,000/$60,000). Upon making the $6,000 conversion, 10% of it will be deemed the after-tax portion. Therefore, the other 90% will be considered by the IRS as a pre-tax conversion. This causes income tax to be owed on the $5,400 pre-tax conversion. Only $600 of the after-tax contribution being moved to the Roth IRA can be non-taxable. Do this a few times and it gets messy trying to keep track of the cost basis in the original IRA account—which then, in many ways, defeats the purpose of doing a back door Roth IRA in the first place.
Is it possible to avoid the Pro-Rata rule? Yes! It involves utilizing your 401(k) account, which is not considered an IRA asset when performing a Roth conversion. You can move the pre-tax funds from the IRA, SIMPLE IRA, and/or SEP IRA into your 401k account, and the after-tax contribution to the IRA will now be 100% of the IRA balance. Moving that amount over to a Roth IRA is a 100% conversion of the after-tax contribution (plus any potential earnings that would be taxable), and it avoids triggering the Pro Rata Rule.
With a little planning and preparation, using the Back Door Roth IRA strategy can significantly enhance tax free income in retirement. This strategy allows individuals who are phased out to make a Roth IRA contribution. Congress has not yet closed the door on this strategy. That may change at some point in the future. Consult with your legal and tax advisors before completing the Back Door Roth IRA to ensure that the strategy is right for you and that the proper tax forms are filed.